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Foul Weather Austrians
I am puzzled by the resurgence of Austrian Business Cycle theory among Sachs, Krugman, Baker and many others who you would not ordinarily associate with the theory. Sachs, for example, writes:
...the US crisis was actually made by the Fed... the Fed turned on the monetary spigots to try to combat an economic slowdown. The Fed pumped money into the US economy and slashed its main interest rate...the Fed held this rate too low for too long.
Monetary expansion generally makes it easier to borrow, and lowers the costs of doing so, throughout the economy. It also tends to weaken the currency and increase inflation. All of this began to happen in the US.
What was distinctive this time was that the new borrowing was concentrated in housing....the Fed, under Greenspan's leadership, stood by as the credit boom gathered steam, barreling toward a subsequent crash.
What is puzzling about this is two-fold. First, there is no standard model that I know of (say of the kind normally taught in graduate school) with these kinds of results. Second and even more puzzling is that the foul-weather Austrians don't seem to draw the natural conclusion from their own analysis.
If the Federal Reserve is responsible for what may be a trillion dollar crash surely we should think about getting rid of the Fed? (n.b. I do not take this position.) The true Austrians, like my colleague Alvaro Vargas Llosa, have long taken exactly this position. So why aren't Sachs, Krugman et al. calling for the gold standard, a strict monetary rule, 100% reserve banking, free banking or some other monetary arrangement? Each of these institutions, of course, has its problems but surely after a trillion dollar loss they are worthy of serious consideration.
Nevertheless, I haven't heard any ideas, from those blaming the crash on the Fed and Alan Greenspan, about fundamental monetary reform. (Can Sachs, Krugman et al. really believe that it was Greenspan the man and not the institution that is to blame? That seems naive.)
Instead, the foul weather Austrians seem at most to call for regulatory reform. But that too is peculiar. Put aside the fact that banking is already heavily regulated, have these economists not absorbed the Lucas critique? In short, suppose that whatever regulation these economist want had been put in place in earlier years. Would the crash have been avoided or would the Fed have simply pushed harder to lower interest rates? After all, the Fed lowered rates for a reason and if the regulation reduced the effectiveness of monetary policy in creating a boom well then that just calls for more money.
Posted by Alex Tabarrok on April 2, 2008 at 07:43 AM in Economics | Permalink
Comments
we just need the *right* greenspan in there, alex. c'mon, man.
Posted by: shawn at Apr 2, 2008 8:21:23 AM
Expanding on Shawn's comment, there's a certain segment of the population who believes that government is an unmitigated force for good. Except when *those* guys are in control. When bad things happen, it's those guys fault, not a failing of the institution.
If per chance *our* guys are in charge when bad things happen, it's still not a failing of the institution nor is it the fault of our guys. Instead, *we* were a victim of forces beyond our control and if only we can bring those forces under government purview, then all will be right in the world.
==========
Krugman pretty clearly falls into this camp, which is why he doesn't view current problems (such as they are) as a fault of the institution and views them instead as the fault of the wrong team managing the institution.
Posted by: Jody at Apr 2, 2008 8:33:02 AM
What was distinctive this time was that the new borrowing was concentrated in housing....the Fed, under Greenspan's leadership, stood by as the credit boom gathered steam, barreling toward a subsequent crash.
If the housing bubble was caused by low interest rates and is the Fed's fault, then how do they account for the greater run-ups in housing prices elsewhere? An excerpt from the recent End of the Irish Miracle piece:
"The average house price topped $490,000 at the beginning of last year, an increase of more than 300% in just over a decade, compared with 130% in the U.S."
Here's the situation for the UK:
"UK house prices 'nearly tripled'. Average house prices have nearly tripled across the whole country during the past decade"
http://news.bbc.co.uk/1/hi/business/6090972.stm
And what about the euro-zone as a whole?
"The euro area average index of real housing prices has risen almost as much as that of the US and is now (as that of the US) about 40% above its 30-year average."
http://www.voxeu.org/index.php?q=node/642
But I'm sure that Krugman, et al know this perfectly well. So what game are they playing? Election year politics, obviously (and in that game an argument doesn't have to right to be useful).
Posted by: Slocum at Apr 2, 2008 8:39:19 AM
Provide the context the small segments you quote and overanalyze. Dumbing down Krugman's critique of the Fed to one sentence and the drawing a conclusion like 'he must call for the Fed to be abolished' is facile.
Posted by: Mark at Apr 2, 2008 8:56:38 AM
The whole Austrian thing is too inside-baseball for me.
When an institution works pretty well for a century, maybe it works pretty well, in general. Maybe "taking away the punch-bowl" is a critical piece of making it work.
I think the bigger, scarier, issue is that congress is considering props to keep the house-bubble inflated(!)
Posted by: odograph at Apr 2, 2008 9:29:55 AM
"Can Sachs, Krugman et al. really believe that it was Greenspan the man and not the institution that is to blame? That seems naive."
Good point. Any POTUS would have invaded Iraq post 9/11, for example.
Posted by: meter at Apr 2, 2008 9:30:28 AM
These men are not writing as economists. They are writing for the political sphere of debate. When they have written for the technical sphere, I bet they said different things.
Also, remember that these are people who generally see the world as needing to be controlled from the top. When something bad or good happens, the top is where they will look. That's the paradigm they follow.
Posted by: bobvis at Apr 2, 2008 9:32:56 AM
Very few people who want to retain their status as "serious" thinkers will publically call for the same things Ron Paul did, for fear of a serious decline in the quality of their groupies being tarred as a "Ron Paul-loving nutjob".
A little more seriously, Austrian economics has a strong normative aspect, but the analytical tools don't necessarily lead to the same normative conclusions. When the Fed actually was trying to keep inflation low, the Austrian's critiques sounded awfully strained. After two large bubbles have popped within 7 years, there's more strength to their arguments, but the political reality is that we aren't going to abolish the Fed anytime soon, so figuring out what the Fed should do (or shoul dhave done) is a more fruitful exercise than calling for its abolition. Ronald Reagan got elected president by calling for the Fed to tighten monetary policy to reduce inflation and the harms following it. Ronald Paul became a laughingstock by calling for the abolition of the Fed.
Posted by: Anthony at Apr 2, 2008 10:04:36 AM
Maybe it's the Ron Paul effect.
Posted by: 8 at Apr 2, 2008 10:06:33 AM
"When an institution works pretty well for a century, maybe it works pretty well, in general"
Over the last century we have had a Great Depression and a number of large recessions. Why do you call that working well?
Posted by: assman at Apr 2, 2008 10:11:19 AM
Slocum, anecdotally it seems to me that the EU runup in RE prices lagged the US.
Spain, for example, started to crumble after our market did.
Posted by: meter at Apr 2, 2008 10:15:25 AM
I was rounding-up, using the post-Depression Fed as my starting point ;-)
Posted by: odograph at Apr 2, 2008 10:15:39 AM
I think the difference between Ron Reagan and Ron Paul had more to do with their demeanor than their policy prescriptions. True, Reagan slowly moderated from his initial Reason Interview stances, due to the realities of Washington, but his platform was not timid, when running against Carter and the 1970s economic concepts of Galbraith et al.
The difference is that Ron Reagan spoke with pride and humor about a strong free market America and a crazy, foolish and evil communist Russia; while Ron Paul whines about inflation and the Fed.
Posted by: liberty at Apr 2, 2008 10:19:03 AM
"When the Fed actually was trying to keep inflation low"
Depends what you mean by keeping inflation low...according to the productivity norm there should be deflation when productivity increases:
http://macromarketmusings.blogspot.com/2007/09/mark-toma-points-us-to-knzn-who-is.html
http://www.cato.org/pubs/journal/cj10n1/cj10n1-14.pdf
Posted by: assman at Apr 2, 2008 10:20:20 AM
From Odograph:
When an institution works pretty well for a century, maybe it works pretty well, in general. Maybe "taking away the punch-bowl" is a critical piece of making it work.
Then, later:
I was rounding-up, using the post-Depression Fed as my starting point
So, were you then conceding the point that maybe the Fed has not worked well at all? One could also add in all the central banks that have failed in the past, and the other ones committing the same errors today.
The current crisis will likely pass, but the errors get larger and larger over time as total debt always outstrips total output. Eventually the entire edifice collapses.
As for Krugman and his ilk, they will be inflationist cheerleaders once Democrats are in the presidency. They have no intellectual honesty.
Posted by: Yancey Ward at Apr 2, 2008 10:43:02 AM
Just because you believe money was too cheap doesn't mean you subscribe to an Austrian-style understanding of central bank policy.
But I doubt money was cheap in the sense of low interest rates. I bet if you really pressed Krugman et al. they would come to agree with Robert Reich: Why did the Fed choose, in the midst of an easing cycle, to also ease lending standards with respect to both documentation and to performance bond (i.e. down payment)?
Any properly functioning market, like a futures exchange, has a type of performance bond embedded. Greenspan threw this baby out with the bathwater of excessively high interest rates, and now Bernanke is left to clean up the mess.
Overleveraging does not occur from low interest rates, it occurs from low lending standards and low margining. A simple 10-20% down payment would have kept stability in these markets.
This is the aspect of the credit process the Fed failed on. It has nothing to do with fiat currency.
Posted by: Alex Reed at Apr 2, 2008 10:45:30 AM
Slocum, anecdotally it seems to me that the EU runup in RE prices lagged the US.
Spain, for example, started to crumble after our market did.
Yes, but the point is no Greenspan easy-money policies (that allegedly caused the U.S. housing price run-up) have been in effect in the UK and eurozone markets.
Posted by: Slocum at Apr 2, 2008 10:46:41 AM
I'm not getting you, Slocum. Didn't the Fed as we know it only start after the Great Depression? And since then haven't we only had less than catastrophic business cycles?
What if that's as good as it gets?
Now assuredly the current situation with rampant debt is a serious issue, but we could argue it is what comes when the Fed model is overthrown (no punchbowl removal, no banking oversight) rather than what happens when it is adhered to.
... you weren't one of the "free the markets" boys, were you?
Posted by: odograph at Apr 2, 2008 11:07:44 AM
Alex Reed,
I think Tabarrok is correct- keeping lending standards higher, or even raising them would have been contrary to the outcomes desired. If lending standards had been kept fixed, then the low interest rate policy would not have had the desired effect. The Fed would then have had to lower rates even more (or found even more ways to extend credit), and you would have ended up in the same place.
Posted by: Yancey Ward at Apr 2, 2008 11:11:24 AM
You don't sense any tautology there Yancey?
What if, because lending standards and reasonable debt limits were considered important, we had ended up some place else?
Posted by: odograph at Apr 2, 2008 11:15:25 AM
Odograph,
The Fed was instituted in 1913, during the Wilson administration. Though the country was technically on a gold standard, that was, in fact, a fraud, as was demonstrated by 1933's dollar devaluation (another fraud that was demonstrated by 1971's breaking of the final link between gold and the dollar).
No, the Fed get a lot of the blame for the Great Depression, it gets a lot of the blame for the stagflation of the 1970s and the deep recession of the early 1980s, and the present mess is almost entirely blamable on the Greenspan Fed's less-than-zero real interest rate policies.
A central bank can work if you can guarantee that it will maintain a fairly stable monetary unit, but such a central bank has never existed. This suggests that it will never exist. And once you start down the inflationary path, the incentives are to never deviate and to only accelerate the rate.
There are only two options: (1) inflate the debt away and destroy the currency, or (2) allow the debts to be realized and losses assigned to the proper parties. No one in government ever advocates the second of these options.
Posted by: Yancey Ward at Apr 2, 2008 11:25:02 AM
Odograph,
If we were intended to end up somewhere else, then there would have been no artificial suppressing of interest rates in the first place. It is not a tautology, it is a simple recognition of the actual goals of the lower interest rate policies. Higher lending standards were contrary to those goals. If lending standards had not come down, then the Fed would have had to lower interest rates even more, and you would still have ended up with this banking crisis.
Posted by: Yancey Ward at Apr 2, 2008 11:29:57 AM
OK, maybe I'm thinking of the whole matrix of post-Depression institutions and mechanisms which (to my mind) formed a moderate, regulated, market, economy.
That didn't seem to bad to me ... until something happened in the 70's and 80's. And at this point I still see that 70's/80's thing as a breaking point, and inflection from past patterns, rather than the 1913-present rule.
Posted by: odograph at Apr 2, 2008 12:00:09 PM
We want to put all the blame on Greenspan because this allows us to personify the problem -- and personify it somewhere else.
This allows us to ignore the stupidity of homeowners who overleveraged themselves, the fraud or near-fraud involved in passing bad-bet mortgages through the system, the faulty statistical models, the overleveraging of Wall St firms, the "off book" stuff that wasn't far enough "off book", etc. (tired of typing).
Posted by: zbicyclist at Apr 2, 2008 1:26:23 PM
Odograph,
What past pattern? There is no pattern that existed in the past that we don't see today. It is a boom/bust cycle caused by credit expansion and credit contraction. A central bank just makes it systemic.
I realize the past pattern you are trying to identify with is the period of 1950s to the 1970s, but trying to find something unique in that period of boom compared to, lets say, the boom period of 1983- 2000 is just fallacious.
Posted by: Yancey Ward at Apr 2, 2008 1:29:11 PM
Yancey--
The goals/mandates of the Fed are twofold: price stability and economic growth/full employment.
True, lower lending standards caused more credit to flow into the economy and therefore boosted economic growth. However, this was a short-term effect. Moreover this credit increase primarily affected the housing markets but not necessarily the greater economy. Over time the only affects on the greater economy were, in hindsight, overdone allocations of capital towards real estate.
Then banks were unable to price derivatives based on housing from uncertainty in 1) foreclosure levels and 2) repayment quality of the debtors. Both of these problems were caused by reduced lending standards and not low interest rates. True, the securitization process bears some responsibility, but the Fed should have protected creditors from ever needing to worry the securities could have been backed by such unreliable borrowers.
The problems behind these derivatives made for major volatility in the secondary credit markets (i.e. reduced price stability) and also makes for potentially major disruptions in the greater credit market via bank failures, reducing the amount of credit in the economy and therefore total economic growth. This is the scenario that the "credit snobs" were most worried about and rightfully so.
I'm not sure what goals you have in mind when you say lending standards were loosened towards "actual goals of the lower interest rate policies." What were these goals? I believe the Fed has two simple goals, and in my view the policy of laxened lending standards met neither one.
Posted by: Alex Reed at Apr 2, 2008 1:31:04 PM
Yancey, the wikipedia page for the Federal Reserve shows money supply taking off big time around 1980.
If the Fed (and broader gov policy) was constant, what caused that?
Posted by: odograph at Apr 2, 2008 1:51:40 PM
"banking is already heavily regulated" -- says who? Banking has been deregulated and that is the crux of the problem. And monetarism has never been tried.
"Free gratis" legal reserves, as contrasted to liquidity/prudential reserves (those which Bernanke utilizes today), are a necessary requirement of all money creating institutions, with the exception of Central Banks.
Barring the necessary legal restraints, money creating depository institutions will create an excessive volume of money.
Barring direct authoritarian controls, the only method by which the volume of money can be properly regulated is through central bank control of commercial bank "free gratis" legal reserves and reserve ratios (the minimal ratios of legal reserve assets held by the commercial banks to their deposit liabilities).
The first initiative should be to require all banks to have the same legal reserve requirements, both as to types of assets eligible for reserves and the level of reserve ratios. Then the Fed should limit ALL reserves, to balances in the Federal Reserve banks (IBDDs), and have UNIFORM reserve ratios, for ALL deposits, in ALL banks, irrespective of size.
And if the money supply is controlled properly, then the determination of interest rates can be left to free market forces.
Otherwise, the effect of tying open market policy to a fed Funds bracket (Bernanke's policy) is to supply additional (and excessive legal reserves) to the banking system when loan demand increases
As it is, the effect of Fed operations on all other (except discount, PCDF, TDWP - pegs in the short run) interest rates is INDIRECT, and varies widely over TIME, and in MAGNITUDE.
The money supply is not self-regulating. The money creating depository institutions must be severly regulated in the managment of both their ASSETS & their LIABILITIES. The operations of these institutions cannot be ruled by deregulation. Their operations must be severly circumscribed and subject to rigorous and informed supervision.
Posted by: flow5 at Apr 2, 2008 1:52:19 PM
If the Fed (and broader gov policy) was constant, what caused that? odograph:
The crux of the cause of our monetary mismanagement, especially since 1965, is the assumption that the money supply can be managed through interest rates, specifically the federal funds rate. We should have learned the falsity of that assumption in the Dec. 1941-Mar. 1951 period. That was what the Treas. – Fed. Res. Accord of Mar. 1951 was all about. During Vocker's tenure, he just widened the Fed Funds Bracket-Racket.
Even worse, Paul Volcker targeted non-borrowed reserves instead of total reserves. That is, today Bernanke is using only borrowed reserves in his control of the creation of new money & credit. That is, one dollar of borrowed reserves has the same legal-economic base for expansion of the money supply as one dollar of non-borrowed reserves. At times during 1979-1983 period, borrowed reserves were 10% of total reserves. And so it was obviously impossible to control the money supply using non-borrowed reserves as a policy rule.
Posted by: flow5 at Apr 2, 2008 2:04:06 PM
Alex,
Lax lending standards meets the second of the two goals you mentioned, as do the ridiculously low short-term rates (which are just another form of lax standards). Remember, the boom in housing did contribute to economic growth as did the previous boom in hi-tech. The Fed has no skill in directing cheap credit towards specific areas, and even if it did, it would fall prey to rent-seekers looking to take advantage of easy money.
I would argue that price stability really isn't a goal of the Fed at all, at least not since Paul Volcker was the chairman.
Posted by: Yancey Ward at Apr 2, 2008 2:04:32 PM
Odograph,
Uh, no. What the Wikipedia page shows is that broad money supply has been growing geometrically nearly non-stop since the inception of the Fed. There have been lowering of the rates of growth from time to to time, but the trend is up, and up more, nearly the entire time of the Fed's life.
You really need a logarithmic scale to see this trend in the correct perspective. I will see if I can dig one up.
Posted by: Yancey Ward at Apr 2, 2008 2:14:52 PM
There is a "log money supply" graph on this page, the graph itself is titled "Greenspan's M3 Money Supply"
Posted by: odograph at Apr 2, 2008 3:47:17 PM
From 1982 to the most recent data point the money supply is up 117%. The prior 25 year period the money supply was up 240%. So based on this time period the expansion of the money supply has decelerated.
Posted by: Jay at Apr 2, 2008 3:53:28 PM
Krugman et al. give a nod to Austrian theory because that's the only game in town as an explanation of the buble and its aftermath.
Krugman by the way gave a nod to Hayek in a column a few years ago, but recall that he trashed ABCT in a Slate article in 1998, calling it the "overhang" theory.
Which showed that he didn't have a clue what it's about.
The Austrians put interest rates front and center, and more importantly, emphasize the economic coordination role they play in investment, employment, and the structure of production. This omission is a key flaw in monetarism.
Would it be incorrect to say this insight is not present in modern macroeconomics save in the work of the Austrians?
Posted by: Bill Stepp at Apr 2, 2008 5:36:41 PM
Problem was not Greenspan, lax regulation so much as inflation targets that overlooked asset prices. For more detail see:
Ensuring financial stability
March 27, 2008
How to fix the error in monetary policy.
http://www.canadianbusiness.com/columnists/larry_macdonald/index.jsp
Posted by: larry macdonald at Apr 2, 2008 5:45:39 PM
Larry,
I agree that the CPI is flawed and a better measure would include asset prices.
But why should the Fed be in the business of doing this anyway, given that it works by targeting interest rates? This interferes with the coordinating work of interest rates and necessarily results in asset bubbles.
What we need is to abolish the Fed and have a system of free banking.
I disagree with your assertion that the U.S. is heading for deflation.
Here is an assignment for you if you write for a Canadian publication:
write a column/article on why Canada avoided the worst ravages of the Great Depression, unlike its neighbor to the south.
Two reasons: 1. The U.S. had a central bank, which blundered badly; Canada didn't have one until 1935, well after the worst of the depression was over. Thus Canada avoided the deflationary meltdown that bedeviled the American economy.
2. The U.S. had anti-branch banking laws, which kept banks artificially small, impeded their growth, and made it impossible for them to gain access to the capital that would have stemmed the bank runs that caused the U.S. banking system to collapse in 1930 and 1931. Canada, which had no such restrictions, experienced no bank failures--repeat, not one--during this time.
Between 1931 and 1935, 22 states repealed these laws; this is why such a catastrophe will likely never be repeated.
Bill
Posted by: Bill Stepp at Apr 2, 2008 6:42:53 PM
This isn't totally on-topic, but I'd really like to see a mainstream economist seriously address ABCT. I don't think its as powerful an explanation as the folks at LMvI would have us believe (since I think there are plenty of other causes of clusters of bad investments), but there are a few things I've never heard addressed:
If prices coordinate economic activity, what does the rate of interest coordinate?
We know lower interest rates mean more loans are taken out. How much more debt is the 'right' amount?
If the interest rate doesn't coordinate inter-temporal action, what does?
I don't think rational expectations helps at all, because we are talking about irrational actions on the part of groups, not individual actors. As much of modern economics has shown us, rational individual behavior does not necessarily produce good outcomes for a group of individuals.
None of Tyler's critiques of ABCT have made any sense to me. I think he's tried to claim that banks don't have strong incentives to lend out the new funds they acquire, which sounds very wrong to me.
Posted by: Grant at Apr 2, 2008 6:51:53 PM
If you look at the real estate speculation in Florida in the 1920s and the HUD fueled real estate bonanza of the 1960s and 1970s, and recently, you will see common threads: massive speculation, get rich quick mentality, don't be the last to sell. The HUD scam left the taxpayers holding the bag while the banks and real estate brokers got rich. The recent frenzy left the investors and people who lent to them (banks) holding the bag while mortgage brokers and mortgage companies got rich. Of course, the speculators were lying on the mortgage applications, too. Mortgage companies were all too willing to look the other way as long as they could sell the mortgages in the secondary market.
It tells us more about human nature than economics.
Posted by: jorod at Apr 2, 2008 9:56:18 PM
Markets are efficient as long as they pause to look at the information available and analyze it. The problem with human nature is it doesn't always wait for enough information to make an intelligent decision. There is that herd instinct, the feeding frenzy part in our brains from primitive days that helped us survive in more dangerous times. Now it can be a hindrance to the use of common sense.
Posted by: jorod at Apr 2, 2008 10:04:20 PM
If prices coordinate economic activity, what does the rate of interest coordinate?
We know lower interest rates mean more loans are taken out. How much more debt is the 'right' amount?
If the interest rate doesn't coordinate inter-temporal action, what does?
The natural rate of interest is determined by peoples' time preferences; this equilibrates the supply of and demand for loanable funds or more broadly investible resources. So the answer to the first question is that the rate of interest does coordinate economic activity--investment and the structure of production--in conjunction with prices. Together they equilibrate the markets for present and future goods, including money (a present good) and capital (a future good), as well as consumers' goods (present goods), and labor.
The right amount of debt is whatever is taken out on the unhampered market, i.e. a market in which there is no central monetary planning and no interference with the rate of interest. Under such a free banking system, the loan rate automatically adjusts to the natural rate and moves in tandem with it.
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Posted by: paine at Apr 2, 2008 10:39:00 PM
Bill, I understand the Austrian position, I was trying to understand how the ABCT critic would answer those questions.
jorod, I think thats sometimes correct, but that doesn't say anything about markets, only human nature. The question is how to reduce those tendencies? The only way I can think of is to make sure people bear consequences of their actions, good or bad, and generally don't pass those on to others through externalities.
Posted by: Grant at Apr 3, 2008 12:35:57 AM
Grant,
Try Bryan Caplan's critique of Austrian economics here. Scroll down to section 3.4 where he critiques the ABCT.
Posted by: Dan in EuroLand at Apr 3, 2008 3:40:30 AM
Dan,
I've read a good amount of it, and Bryan does make some good points. But I think overlooks some things in his dismissal of Garrison's objection to rational expectations. Specifically, he seems to assume that incentives being aligned with the longer-term goals of society is a normal thing. I believe Hayek made a strong case that this isn't at all normal, but is attributable to the marvel of the market process and the knowledge conveyed by aggregated by prices. Absent markets, bad and even terrible results are the norm. I don't think ABCT ever described individual entrepreneurs being "fooled", but rather incorrect prices altering the incentives in such way that the market itself was "fooled" into producing things that no one wants. The entrepreneurs were pursuing their self-interest, but it led to nasty results (e.g., what is normally known as "flipping" assets, which a lot of people make a lot of money off of).
Even still, its nigh-impossible for entrepreneurs to predict what the "correct" market prices will be in the absence of interference. Just look at how many people argue over what housing prices will do. There are always more would-be capitalists out there asking for investment than will receive it. Given this, and the strong incentives banks have to lend out available funds during times of low interest rates (especially for assets that "can't go down in value"), I think what follows shouldn't surprise anyone. Asking a publicly-traded bank to take a hit on this quarter's earnings in order to possibly make more during a supposed recession is, according to the banking executives I've spoken to, a non-starter (the quarterly-focus of Wall Street is another odd thing, and is probably indirectly related to some downturns). In short, I think Bryan underestimates just how blind people are without prices to guide them.
His assertion that ABCT predicts lower unemployment and higher output during the bust is, as far as I can tell, totally incorrect.
Posted by: Grant at Apr 3, 2008 4:18:55 AM
Oh, and more to the point, Bryan doesn't seem to offer any alternative to view to what interest rates do, how they should be "set", or what the effects of the Fed's manipulations are. Thats really what I'm after: An explanation of intertemporal coordination and interest rates that does not require one to accept ABCT on some level. As I've said before, I'm not convinced ABCT is nearly as significant as the LvMI thinks it is (given the many other likely causes of clusters of malinvestments), but I'm not convinced its as useless as many of the GMU bloggers seem to indicate.
Posted by: Grant at Apr 3, 2008 4:25:11 AM
I'm with Grant on this one. The ABCT describes one aspect of macroeconomics, namely how microeconomics interacts with macroeconomics. There are probably other aspects that need understanding too. But ABCT is much more useful than most economists think.
Tabbarok:"Can Sachs, Krugman et al. really believe that it was Greenspan the man and not the institution that is to blame? That seems naive."
Meter:"Good point. Any POTUS would have invaded Iraq post 9/11, for example."
There is a big difference between the two positions. The president has wide leeway to do what he thinks is best. The chairman of the Fed has very little, at least in the arena of interest rate policy. The Fed chairman is bound to obey the fixed aims set by US Federal government, as Alex Reed mentions.
Grant:"I think he's tried to claim that banks don't have strong incentives to lend out the new funds they acquire, which sounds very wrong to me."
He did, it is a theory of Fisher Black. I think he is partially right, in some situations banks will not be able to find suitable candidates to lend to and will not lend out the money. This happened in the great depression. Its also worth mentioning that Austrian theory accounts for the possibility of this happening.
Certainly low credit standards have not helped during this boom. However to expand on Alex Tabbarok's point about the Lucas critique. In Britain we have had a housing boom just like in the US. But we have had much higher interest rates through the same period. Even in real terms interest rates have been higher.
So, why did it happen? Read http://en.wikipedia.org/wiki/Offset_mortgage and note the part on tax advantages.
Posted by: Anonymous at Apr 3, 2008 5:41:57 AM
Austrian Business Cycle Theory is incorrect.
Posted by: Robert at Apr 3, 2008 6:54:01 AM
Robert:Austrian Business Cycle Theory is incorrect.
That is a gated paper. Can you tell us what its arguments are?
Posted by: Anonymous at Apr 3, 2008 7:50:30 AM
I haven't read Robert's paper yet, but the precis makes it sound like he doesn't understand Hayek, who rejected the concept of the ave. period of production (for good reason).
Also, ABCT doesn't depend for its validity on a Hayekian triangle, which is only one way to look at ABCT.
As to the other criticism above about the macro/micro/(other?) trichotomy, what praytell is there other than micro- and macroeconomics?
Posted by: Bill Stepp at Apr 3, 2008 7:52:12 AM
Anonymous, you can download it free from one of the links on the page, just scroll down a bit. Wikipedia seems to have similar content here: http://en.wikipedia.org/wiki/Capital_controversy
The Hayekian triangle, as I understand it, is more of a teaching tool than a serious illustration of capital. The same with assigning goods as being strictly "higher" or "lower" order, since the order(s) of a good is dependent on the production process.
Capital reswitching is taught, although not by that name, to most business and engineering students, who call it cost-benefit analysis. As the interest rate changes, the optimal means of production can change, and then change again to be back where one started. I definitely found it counter-intuitive at first (frankly, I found that engineering economics course to be much more enlightening on capital theory than any work of economics I've read; I oftentimes think economists need to get out more).
I am not sure how reswitching and the lack of a monotonic relationship between the interest rate and capital utilization invalidates ABCT? The "bust" phase of ABCT occurs because the production of the market is too future-oriented, and so the factors of production must be reorganized in a way that serves the demands of consumers. It doesn't seem like one would need a theory of capital to explain this at all; homogeneous capital would probably even work. I could see reswitching playing a roll in the recovery phase, where capital must be re-allocated. Capital which could be reswitched instead of being scrapped completely or abandoned would surely speed recovery from the recession, but surely the costly re-allocation of capital of all sorts would still cause problems. Maybe I'm misunderstanding the paper?
But then I've always thought of ABCT as not being about capital per se, but rigidities (such as capital allocation, menu costs and business plans in general) having to be reallocated due to discoordination caused by manipulated prices. To me, capital was always just a convenient way of explaining the process, more of a teaching tool, like the Hayekian triangle. However, I've really only read Garrison and Mulligan (who wrote a good paper framing menu costs in terms of ABCT) on it.
Posted by: Grant at Apr 3, 2008 8:47:46 AM
Grant,
What do you think about the argument that investors will err, but their errors won't be systematically biased? ie some investors will think the real interest rate is higher, some will think it is lower, and so capital won't be future-oriented due solely to lower nominal rates?
I think that flipping may overcome this, along with rigidities the government instills in the capital market, but I don't have a strong theory for this to present to you, it just seems intuitive. (My feeling is that ABCT can explain a lot, but needs some updating and expansion.)
Posted by: liberty at Apr 3, 2008 9:17:20 AM
Me: "The ABCT describes one aspect of macroeconomics, namely how microeconomics interacts with macroeconomics. There are probably other aspects that need understanding too. But ABCT is much more useful than most economists think."
Bill Steep: "As to the other criticism above about the macro/micro/(other?) trichotomy, what praytell is there other than micro- and macroeconomics?"
I didn't mean there is anything other.
What I mean is that Austrian theory does not preclude other theories being true in part. It gives accounts of causes for recession. Other theories, such as the Keynesian ones focusing on demand give reasons for recession to become reinforcing. They may be wrong but they are worth investigating. Also, wage and price stickiness appear to exist, probably in many sectors of the economy.
What I mean is there should be some attempt to integrate the various divergent theories into a whole. The whole may be useless and contradictory, but its at least worth a try.
Posted by: Anonymous at Apr 3, 2008 9:34:14 AM
Hmm, I'd never thought of flipping in that context.
If investor's estimates of the real rate of interest is all over the place, would that create an arbitrage opportunity between the the lower estimators and the higher ones? They'd be willing to pay more for capital they thought would yield a better present worth.
Suppose we had 4 investors who each owned identical pieces of capital making them $100 per year, but each estimated the real interest rate differently. So they'd estimate the present worth of each piece of capital as being:
A 5% $95
B 15% $87
C 25% $80
D 35% $74
I would think that regardless of the true interest rate, A would end up owning the most capital, while D would end up owning the least. So the capital falls into the hands of the person most likely employ it for uses too far in the future? Property is flipped towards people with ever-decreasing opinions on real interest rates? Would the same analysis apply to banks borrowing reserves from each other, meaning the most irresponsible banks would get most of the dough because they'd be willing to pay the most for it?
In normal situations, I'd think different estimates of the value of a factor of production to be a good thing, because they'd represent the Hayekian knowledge each individual had on how best to use that factor. But in this case most of the actors won't have specialized, local knowledge of the rate of interest, they'll just be wrong.
Am I way off on this? I've been coding for about 15 hours straight now, so I may well be :P
Posted by: Grant at Apr 3, 2008 9:55:51 AM
Ah, reswitching. That is a very theoretical argument. Common sense indicates that given more time to figure out a production process a product can be produced for a cheaper price.
I am an engineer and deal with "cost benefit analysis" of products often and I've never found this not to be the case.
Posted by: Anonymous at Apr 3, 2008 9:56:54 AM
Grant,
In your example: what is the real interest rate? At what point do these investments fail?
If some people overestimate the real interest rate, they will be less likely to invest in long term projects because they will expect it to rise later, hence they will reduce the total amount of long-term investment. Yes, those who underestimate it will get the most long-term capital, but that doesn't mean that the average length will necessarily increase.
For example, if most people overestimated the true rate, you'd have reduced long term investment. If most people underestimate it (the usual ABCT story maybe) then you'd have too much long-term investment. But if some err one way and some the other, they would cancel each other out.
I think thats the theory. Did I misunderstand you?
Posted by: liberty at Apr 3, 2008 4:40:01 PM
Bill Stepp says:
> I haven't read Robert's paper yet, but the precis makes
> it sound like he doesn't understand Hayek, who rejected
> the concept of the ave. period of production (for good
> reason).
And yet the abstract says:
"The rejection, as is typical of the modern Austrian school of economics, of a physical measure of the average period of production ... is not sufficient for rigorous capital theory."
> Also, ABCT doesn't depend for its validity on a Hayekian
> triangle, which is only one way to look at ABCT.
And yet the abstract says:
"No tendency need exist for entrepreneurs to respond to
lower interest rates by reallocating resources from
producing low order goods to producing higher order
goods..."
Grant says:
> assigning goods as being strictly "higher" or "lower"
> order, [is more of a teaching tool] since the order(s)
> of a good is dependent on the production process.
Section 3.1 consider production processes. And even
here goods cannot be assigned ambiguously to
orders.
I could go on about more mistakes of some posters.
Grant might consider footnotes 14 and 49 (if I
understand the versions of this paper correctly).
Posted by: Robert at Apr 3, 2008 6:20:26 PM
Regardless of what Krugman, Sachs, or Paul might think, the new currencies are already here. The big boys don't trust the Fed any more, nor even the euro, so they are brewing up something better. It's Carl Menger on derivatives.
Posted by: bostonian at Apr 3, 2008 8:25:56 PM
liberty,
But if some err one way and some the other, they would cancel each other out.
You'd have some investors with too much of a long-term focus, and others with too much of a short-term focus. I agree the mean 'length' wouldn't increase, but you'd still have widespread malinvestments, wouldn't you? Those under-estimators would own the long-term projects, and use those projects to undertake projects which would more easily fail as they would tend to have difficulty paying back creditors (in the case of fixed interest rate loans, the creditor would have more difficulty staying solvent, having loaned out funds at a too-low of a rate).
Of course, I think its very dubious to assume that entrepreneurs would even think to consider what a 'natural' rate of interest would be, or have any knowledge of ABCT. I've never spoken to one who had ever heard of it. Many don't even have a theoretical understanding of prices as signals in the economy.
Robert,
I am wondering two things:
1) How much capital reswitching occurs in practice? There is a footnote about empirical evidence of it, but I haven't followed up on it.
2) There is of course still a tendancy for entrepreneurs to invest in longer-term gains with lower interest rates. I wonder how much ABCT really depends on its theory of capital vs. a more general theory of rigidities in business planning? I suppose this question is left open in the paper, though.
Posted by: Grant at Apr 3, 2008 11:22:25 PM
I think entrepreneurs have a rather good understanding of this, surprisingly enough.
I work in a large computer manufacturing company. This company does everything it can to avoid having long supply lines. It insists that suppliers own the components almost until the last minute a computer is assembled. Then once the components are bought the money only changes hands after a payment period. It keeps virtually no stock. The suppliers behave in a similar way, they keep rather more stock though. They can afford to since their cost per component is low most of the cost in computer components is the R&D to design them.
For all this effort much time is involved in making products. My company start cooperating with the component companies on design years earlier. The component companies begin R&D maybe 5 years before the product is sold. The major tooling costs to build things like silicon masks occur years before the product is sold in many cases.
I think its quite correct that businessmen don't look at the interest rate much. However, they look at opportunity cost. If a process to end product is too slow then that can cost more because of the lost opportunity of allocating resources to faster products. The opposite can occur too. It may be a mistake to invest in projects that are too short.
Suppliers of components - which are often medium size companies - borrow to finance their investments. Some don't borrow, but the financiers that own them do, or they compare their returns to benchmark rates such as the Dow and interest rates. Anyway, if interest rates are low then it is in the interest of the component suppliers to perfect everything. They can have long design cycles and invest years before safely. If interest rates are high they can't.
Some would say "what company only makes the interest rate?" well, very few make that little. However, some lose their market and go bankrupt. Some make losses for years running. So, investors must request a large premium on the interest rate to protect themselves. A company with long term viability is one that can make the interest rate plus this risk premium for its shareholders.
I don't think the natural rate of interest really comes into it, except in uncompetative markets. In competative markets a business must take a similar amount of time over production as its competitors do. If its competitors are willing to wait for years it must be willing to do the same. Otherwise it won't be able to produce products or they will be too expensive.
For example it took years for 802.11n wi-fi to be developed with all the parties involved investing all the way through. Any company whose financiers thought the payoff wasn't worth the wait would have had to have pulled out of the market.
In the world of mobile phones some component vendors have been prepared to lose tens of millions every year for maybe 5 years in the hope of future payoff. These companies have severely damaged the other group who insist on making some profit.
Posted by: Anonymous at Apr 4, 2008 5:30:00 AM
Anonymous, is your company publicly traded? I ask because I've always been told that public businesses are much harder to run with long-term goals. More specifically, I spoke with a board member of a publicly-traded bank who tried to get the other board members to see that the local population of their area was not increasing; in other words, that the sharply rising house prices were a bubble. While many of the board members agreed, they were primarily concerned about the next quarterly earnings report, and so did not heed the warning.
I don't think it was so much that the other board members were stupid as it was that they were following their self-interest: representing their shareholders.
As you say though, I think its much more likely for investors to base decisions off of the rate of interest than businesses.
Posted by: Grant at Apr 4, 2008 6:32:57 AM
"Those under-estimators would own the long-term projects, and use those projects to undertake projects which would more easily fail as they would tend to have difficulty paying back creditors (in the case of fixed interest rate loans, the creditor would have more difficulty staying solvent, having loaned out funds at a too-low of a rate)."
Or, because the other investors are choosing short term projects fewer long-term projects are chosen overall, and they tend to be the less risky (less likely to fail), because they are the best of the crop (investors wanting to do well and all). That is the idea, I think.
"Of course, I think its very dubious to assume that entrepreneurs would even think to consider what a 'natural' rate of interest would be, or have any knowledge of ABCT. I've never spoken to one who had ever heard of it. Many don't even have a theoretical understanding of prices as signals in the economy."
Right, but their tendency to profit maximize makes them aware of inflation and interest rates generally. They do watch what the Fed does. If they see the Fed meddling with interest rates, they take this into account. Notice all the articles on the Fed in business magazines, Wall St. Journal, NY Times, etc. They won't have a sophisticated economic analysis, but they probably take it into account in less precise ways - hence they err but their errors cancel out.
Again, just presenting the view - not defending it in full. And I think rigidities mess everything up.
Posted by: liberty at Apr 4, 2008 8:00:56 AM
Yes, the company I work for is publically traded. This does involve the problem you mention, short termism. (I think the root of this problem is that the investors in publically-traded companies often don't trust the management. They don't agree to long terms goals that involve sacrificing near-term profit because they believe that management is really trying to add buffer so noone will notice near-term under-performance.)
However the place I work doesn't have many of these issues. They have worked for years at reducing their capital intensity, and it has been mostly successful.
The companies that supply my employer though, they have all of these issues. Many of those are small companies which are privately held.
I'm not convinced though that small privately held companies suffer any less from the ABCT dynamic than anyone else. The issue is that their investors are benchmarking against the interest rate. I used to work for an electronics startup company which was funded privately by venture capitalists. I worked around cambridge UK where there are many such companies. This situation was similar.
For example venture capitalists will fund startup drug companies for more than 10 years without them turning a profit. This sounds long termist, but regarding their approach to interest rates it isn't. The VCs often borrow to finance what they do. When they invest though they don't invest looking to get a return more than the interest rate. They attempt to invest in the companies they consider best if they can and they compete for them. (Sometimes they fund companies they consider less than good, mostly at unfavourable terms). This means that to compete they must take less profit. For the good companies therefore there is a race to offer the best deal. Any VC who has a view of the future less optimistic than most automatically counts themselves out. They do this in investment "rounds", handing out years of funding at a time.
If the "2nd round funding" of a company coincides with a period of low interest rates, easy credit and optimism then the VCs will invest a lot. If it coincides with tighter conditions then they won't. If VC were actually looking at the long term interest rate then you would not expect that to happen.
Amongst investors in stable companies (such as chains of shops) I think this logic works via leverage. That is, the shops make say 20% and are safe, so it is worth using leverage to invest in them. Since every investor can do this the value (money price) of the chain increases until leverage is no longer worthwhile. The behaviour of private equity companies in these kinds of businesses supports this view that this happens in private companies as well as public ones.
Posted by: Anonymous at Apr 4, 2008 9:16:04 AM
Tyler, you say you don't subscribe to the Austrian theory of the business cycle. I'm interested in reading your opinion on why you don't subscribe. Is it for the same reasons that Bryan Caplan disavowed his erstwhile Austrian appellation?
Posted by: V at Apr 14, 2008 3:59:29 AM
considering what the Fed's founding objectives are, talking of failure now is a bit of an understatement. the facts point unequivocally to it being a failure since the first decade after its inception.
Posted by: flix at May 9, 2008 9:34:22 AM
